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The Risks of ETFs and Passive Investing

June 27th, 2017 by

There’s a dusty old adage that goes something like, “You can’t reinvent the wheel.” Yet many fund managers and financial advisors would like you to believe that they have indeed reinvented the wheel.

This time, the new revolutionary invention is called an ETF.

Properly Assessing Risk

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Before delving deeper into ETFs, some explanation is in order. The penultimate goal for these money managers is to maximize returns while minimizing risk. Unfortunately, these two objectives are at odds with one another: You’re usually trading off greater risk for greater returns, or vice versa. Sadly, there is nowhere in the known universe where investors can reap truly risk-free returns. Economists never fail to acknowledge that nobody’s lunch is ever free.

In the years preceding the financial collapse, a practice known as “financial engineering” became a popular euphemism for “risk-free returns.” Money managers began to pitch the idea that, through the correct alchemical mix of securities and derivatives, one could construct a truly low-risk investment portfolio that still provided strong returns.

This faulty idea was, in retrospect, taken much too far. Infamously, the bundling of mortgages (many of them non-performing) into AAA-rated investment “packages” known as mortgage-backed securities (MBS) was widely believed to be an endless source of risk-free profits. At least, this is how the markets behaved—until the collapse of the housing market caused a cascade of defaults with these supposedly ironclad MBS (emphasis on the last two letters, apparently).

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The idea behind ETFs is similar: a package of securities are bundled into a single portfolio in order to produce a certain desired level of return, usually mimicking a popular sector or index. Much like passive investing, one of the main benefits of ETFs is that they cut down on the trading fees of trying to compile such a portfolio on your own. Essentially, the work of picking “winners” is done for you. The idea of passive investing (simply “buying the index” rather than going through the time and trouble of picking different assets to invest in) is extended to ETFs. This is perhaps why they have become so popular over the past decade.

Interestingly enough, despite this perception of safety, an ETF is a “derivative by any other name” in the words of Investopedia. It is the product of financial engineering, and is little different from the risky securities that were among the main culprits that triggered the financial crisis.

Check back soon and we’ll include a helpful video explainer about gold ETFs!

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.